Fear and Loathing in (Real Estate) Investing

Fear and Loathing in (Real Estate) Investing

by Arthur Jones, Economist

There is little debate within the real estate community—or outside of it for that matter—that the past two years have presented one of the most challenging environments ever encountered by investors. Since the end of 2007, fallout from the financial crisis has caused severe damage to the economy, and property fundamentals across all asset types. As a consequence, property values during the correction declined in excess of 40%, leading to ever-increasing levels of distress, as underwater property owners that had executed high-leverage deals at the market’s peak found they were unable to meet their debt service obligations.

Sources: MIT Center for Real Estate, Real Capital Analytics

Sources: MIT Center for Real Estate, Real Capital Analytics

During the course of the recession, it could be argued, commercial real estate found itself in the midst of a liquidity trap, where falling asset prices and a low inflationary environment caused investors with capital to remain on the sidelines. Moreover, many investors took a wait-and-see approach, hoping to re-enter the market when distress levels forced over-leveraged owners to sell properties for pennies on the dollar. Now, though distress levels remain elevated, there are signs that the market may be on the mend. In particular, cap rates across property types have begun to stabilize and prices are now 4.7% above their October 2009 trough, according to the Moody’s/Real Commercial Property Index.

The shift in the pricing cycle owes a great deal to the flexibility of the FDIC and institutions working with property owners to extend debt payments and rework terms on performing loans, which has helped the market find its cyclical trough. It is also a function of investors with excess capital bidding on quality, to take advantage of the stable returns offered by performing assets with in-place leases. As such, the market has seen an increasing bifurcation, as quality assets continue to see prices bid-up, while distressed and value-added prospects have seen little movement. It is also the case that—despite the turmoil of the past two years—real estate continues to offer those investors who possess the wherewithal to obtain and appropriately digest best-in-class market research, a relatively low-risk return on investment.

Though it may be difficult to view an asset class that has recently experienced price declines in excess of 40% as low-risk, comparing real estate with other asset classes can bear this out. For example, if we compare returns for real estate investment and the stock market—in this case the S&P 500—one can see the distinction between risk and return. A common method used to measure risk-adjust return when comparing portfolios is to use the Sharpe Ratio, which compares the expected return of a given portfolio to the risk-free return—typically government bonds—while adjusting for the portfolio’s volatility.


Where E(R) represents an investor’s expected return, Rf is the risk-free rate of return and σ is the standard deviation of the portfolio. The ratio is simple to interpret: a higher ratio than other portfolios means a higher risk-adjusted return.

Looking at returns and variation over the past thirty years can give us an idea of how the stock market and real estate have performed over the long run and, by assuming that markets tend to mean-revert, we can gain insight into how asset portfolios might perform in the future. The table below contains the average annual return for the stock market, the NCREIF index for all property types, and the NAREIT for all property types, between 1980 and 2010. It also displays the standard deviation of returns over the same period.


Using these inputs and choosing alternative values for our risk-free return, we can derive a schedule of Sharpe Ratios for each investment portfolio. Generally speaking, the risk-free return refers to the yield on the 10-year Treasury bill. The chart below displays the Sharpe Ratio for each portfolio, assuming a range of interest rates; historically rates have tended to range between the current rate of 3.7% and the 30-year average of 7.2%.

Commercial Real Estate Still Offers a Favorable Low-Risk Return

graph econ2

Sources: NCREIF, NAREIT, Standard and Poor's

Adjusting for risk, over the past 30 years, real estate has been a sound investment; and remember—this includes the most recent cycle. In fact, under most interest rate scenarios, real estate returns outperformed the stock market, which is generally perceived to provide solid returns over a 20- to 30-year hold period. Moreover, the premium for real estate over stock under a low interest rate environment—such as we face today and, given global savings rates, may be dealing with for quite some time—is even greater now than it has been historically.
None of this is to say that the commercial real estate heyday has returned, or will return in short order. Capital markets have a great deal of distance to cover before investment again flows freely into the real estate market. That said, with pricing stabilized and showing modest increases that suggest a nascent recovery is just around the corner, it may be time for investors to reconsider their portfolio allocation and the role that commercial real estate can play in maximizing their returns over the next cycle.

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One Response to “Fear and Loathing in (Real Estate) Investing”
  1. It looks like Investors are still searching for the bottom. Thought south Florida was at the bottom, 18 months ago but has dropped some more. Commercial Real estate still looks better than other investments.

    by Net Lease
    on 18. Aug, 2010

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